Deflation

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Deflation

If the price level falls, an economy experiences
price deflation. Rising prices create a number of economic problems.
Because changes in the price level cannot be measured precisely,
increases of less that 1% a year are considered to be deflationary, and
also warrant intervention. Deflation can cause the following economic
problems:

Delayed consumption

Consumers may delay consumption, waiting for prices
to fall even further. This can have a negative impact on
aggregate
demand, output and
incomes.

A rise in debt burdens and a deterrent to borrowing

Deflation
will cause debt burdens to rise for households that have borrowed in the
past. Many consumer and corporate debts are fixed, including fixed
mortgages
and personal loans, and repayments do not fall as prices fall, making
the real price of the debt rise. For firms, falling prices also create a
debt burden because, although revenues fall, debt repayments
may remain at the old level, increasing the real debt burden.

Recession

This is because economic confidence begins to fall
as households and firms
save rather than spend. Long term recession
following deflation is often called the Japanese disease, given that,
for a long period during the 1990s, Japan seemed trapped in a
deflationary spiral.

Causes of deflation

Following a positive
supply shock, AS to AS1, prices fall from P to P1. Consumers may expect
prices to fall further, and delay their consumption. This causes AD to
shift to the left, from AD to AD1. Firms now cut prices further to boost sales and
reduce stocks.

Deflation can be triggered by an increase in
supply. As business
and consumer confidence in the economy declines, AD falls, resulting in
recession.

Investment falls due to a negative accelerator effect
triggering further price reductions as firms must compete
with each other to attract increasingly scarce consumers. This creates a
downward deflationary spiral, which is extremely hard to get out of.